Emerging markets: are risks in Turkey overplayed?

Investors who look through the negative headlines can still find opportunities in Turkey, argues Aaron Grehan.

Political strife is never far from the surface in Turkey. In the past year alone, there has been a failed coup against President Recep Tayyip Erdogan; the resignation of Prime Minister Ahmet Davutoglu; a flare-up of tensions with the European Union and Russia; and terrorist attacks. More recently, on 16 April, came the result of a constitutional referendum that will give more executive powers to the president; a development seen by some as marking the end of Turkish democracy.

Add to the mix more structural anxieties about the strength of official institutions, weaker growth and an external debt that spiked to a record US$421 billion[1] in the second quarter of 2016, and it is unsurprising that both Moody’s and Fitch Ratings have downgraded Turkey’s sovereign rating to junk status.[2]

Turkey’s woes pushed key risk indicators such as credit default swaps to a four-and-a-half year high in December and the currency to an all-time low of TRY3.85[3] versus US dollars in January, making the government’s battle to regain control of the debt burden all the more difficult.

They have also delivered a sharp shock to the country’s bond market, with yields on ten-year Turkish government bonds soaring from below nine per cent last July to an all-time high 11.62 per cent[4] in January. This left Turkey as the second-worst performing emerging debt market in 2016, returning -16.8 per cent[5] in US dollars.

There is no getting away from the fact that Turkey’s high-profile problems are bad news for a country with a high reliance on capital flows to meet its funding needs. However, Aaron Grehan, Deputy Head of Emerging Market Debt at Aviva Investors, believes that, by overplaying politial worries and not focusing on a robust financial system, investors could miss out on the catch-up potential of an appreciably undervalued market.

What has driven the negative sentiment towards Turkey?

The political situation in Turkey has captured headlines for all the wrong reasons. One of the main reasons investors have returned to emerging market debt in recent months is the general rise in political stability across developing nations. However, this has been far from the case with Turkey, with July’s attempted coup proving to be one of the most high-profile global events of 2016.

Until the referendum in April, it could have been argued that politics had been a relatively periperhal issue in 2017, with most of the uncertainty priced into asset valuations. However, President’s Erdogan’s desire to strengthen his grip on power has refocused the market on these risks. His victory, abeit a narrow one, means that Turkish assets should benefit from more short-term political stability. However, the more difficult question is how a possibly less democratic Turkey will be viewed by the markets over the longer term.

Looking away from the noise of politics, the main structural reason why Turkey is out of favour is its strained finances; in particular its large external debt and ongoing current account deficit.

How do you see the country’s finances?

Our macro-economic view continues to see a supportive environment and therefore financing conditions should remain resilient. We do not think the long-term financing prospects for Turkey will be adversely affected by the current political situation and Turkey still appears set to outperform many of its peers on the growth front.

The financing of Turkey’s external requirements has been remarkably resilient over the past decade. Turkish private firms’ (banks and corporates) roll-over ratios dropped below 100 per cent only during the global financial crisis, when international credit contracted globally.

How reslilient is Turkey’s financial system to external risks?

To really understand this, we need a deeper analysis of the banking system. Turkish banks benefit from strong fundamentals on a stand-alone basis and compare well with most banks in emerging markets. Local regulators are sound and proactive, helping banks make a smooth transition to the Basel III accord. Banks’ capitalisation is strong relative to other emerging markets, which gives them room to absorb the impact of currency volatility and other pressures.

The attempted coup was a significant stress test, but banks recovered quickly, as illustrated by the ease with which they were able to refinance their foreign currency syndicated loan facilities at attractive levels. There was also stability of customer deposits, where clients rotated out of US dollar deposits into Turkish lira ones.

The outlook for asset quality remains challenging given Turkey’s position in the economic cycle, although for now the impact has been modest. Foreign exchange lending equates to about a third of lending and could be a source of risk, but is only to corporate clients (unlike in Hungary and Poland) and foreign currency non-performing loans (NPLs) are currently negligible. Banks have room to absorb potential increases in NPLs thanks to strong provisioning and excess reserves. The Turkish banking sector stands out amongst international peers as being one of the few that does not expect to have to materially increase loan loss provisions on the introduction of IFRS 9.

Should Turkey be hiking interest rates?

Hiking interest rates is precisely what Turkey needs as it should keep its currency from depreciating at an unsustainable pace. A series of hikes should also be a catalyst for a tightening of spreads versus US Treasuries. But while the central bank seemed to have ignored President Erdogan’s lack of appetite for higher rates when it tightened policy in November, recently it has appeared more reticent.

However, keeping the domestic consumer happy by not hiking borrowing costs is a short-term fix that will do nothing but increase Turkey’s external debt problems.

What is the bottom line for investors?

Despite its numeous high-profile challenges, Turkey has a number of strengths that make it an attractive investment proposition. Amongst these are the proven willingness and long track record of paying debt; solid – albeit weakening – growth; a strong fiscal framework; positive demographics; pro-business culture; geopolitical importance and sound public finances and banking system.

What investors need to consider is how much risk premium the market will demand for Turkey’s external vulnerabilities and how sensitive investor sentiment is likely to be to the fluctuating political backdrop. With Turkish bonds having regained lost ground this year, there is arguably increased risk to the downside.

Our belief is that current spread levels compensate for the risks that currently exist. We will focus on assessing the potential changes in the external enviroment and their impact on Turkey as well as monitoring the political situation to understand whether risks are increasing materially.

Important Information

Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at 18 April 2017. This commentary is not an investment recommendation and should not be viewed as such. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.

Aaron Grehan

Aaron joined the investment industry and Aviva Investors in March 2000. He was previously a credit fund manager in the liability driven fixed income team managing portfolios for institutional clients.

Experience and qualifications

Aaron joined the credit team in 2004 as a portfolio analyst before becoming an investment analyst in both the LDI FI and Credit teams. Aaron is a CFA® charterholder and holds the investment management certificate.